Oil's backed itself into a corner

Low prices may be a shock to the production system

TOKYO (MarketWatch) -- Imagine what it would be like to watch oil prices climb to a spectacular record high of $150 per barrel and then leave the planet for the next several months.

That's practically what happened to me.

With much fanfare, oil hit an all-time high in July. I dropped off the face of the oil world four months later, and I've come back to find nothing less than a shocking drop in prices.

Here in Tokyo, I take a fresh look on a market I'd been covering for more than 10 years and realize just how much has happened in such a short amount of time. You've heard it before, but I'll say it again: Oil's loss of 54% last year was the biggest on record -- since futures started trading in 1983.

And some analysts say that it's only a matter of time before the industry gets a visible hit in the form of long-term growth.

"Just as the skyrocketing price last summer brought pressure to explore and ramp up new sources quickly, the sudden deflation in price will do the same," said Anthony Sabino, a professor of law at St. John's University, whose legal practice includes oil and gas law. "Without a doubt, [exploration and production] budgets are going to be hurt."

That could be a big mistake, one the industry should have learned from in the past.

"If demand comes roaring back like in 2003-2004, the upstream could be caught flatfooted suffering from the current low oil prices, like the low oil prices back in 1998 helped create the tightness in 2004," said Robert "Tony" Nunan, an assistant general manager at Mitsubishi Corp. in Tokyo.

Mechanics

A good way to gauge what's been going on investment-wise in upstream, or exploration and production, activities is to take a look at drilling rig counts.

"The U.S. rig count responds first as drilling here is an individual company decision," said James Williams, an energy economist at WTRG Economics.

"Most foreign drilling is either a state oil company decision or one made by individual companies after obtaining government approval" so foreign drilling shows a slower response, he explained.

As of Feb. 27, Baker Hughes
BHI, -1.84%
reported that the number of rigs drilling for oil and gas in the U.S. stood at 1,243. That's down 57 rigs since Feb. 20 and down 520 rigs from about a year ago. On the international level, Baker Hughes' count was 1,078 in December 2008, down 18 from a month earlier, but up 42 from December 2007.

In the U.S. overall, about 30% of the drillings rigs "have been shut down and stacked since last summer, and the rate at which they are being shutdown has been escalating," said Charles Perry, president of energy-consulting firm Perry Management.

The likely outcome will be a decline of additions to oil reserves and a lowering of production of both oil and gas in the U.S., he said.

Oil staff reductions have also been a key factor, with unemployment seemingly headed for 7% to 8% after running below 4% for a couple of years, Perry said.

And when drilling activity falls significantly in the U.S., oil production falls "pretty rapidly," with the reduction readily seen in about six months, he said, citing a recent study.

In the meantime, "the current recession will continue to curtain demand, crimp budgets and overall, just compel major oil players to back off major exploration projects," said Sabino.

He considers that process to "potentially be disastrous because once the world economy makes a comeback, the industry will be caught short and prices will zoom once again."

Perry points out that "when drilling picks back up, it takes about four years to catch up and see any significant increase in oil and/or gas production."

Major players

Indeed, the steep drop in oil prices provides a dilemma for oil companies, which have to guess future trends.

"The steep drop in crude prices over the past year has been a boon for consumers but a great bane for oil producers," said Thomas Hartmann, an analyst at Altavest Worldwide Trading.

'The steep drop in crude prices over the past year has been a boon for consumers but a great bane for oil producers.'
Thomas Hartmann, Altavest Worldwide Trading

"The industry cannot simply stop looking for oil and other carbon-based energy products," he said. "The world will still be heavily reliant on fossil fuels for decades to come."

Oil companies are lowering exploration and production spending by 18% this year, said Brodrick, a natural-resources analyst at MoneyandMarkets.com, citing an estimate from Barclays Capital. "I think they'll cut more than that if prices stay under $50 a barrel."

Chevron's capital program for 2009 is $22.8 billion, unchanged from 2008, though 10% of the total 2009 budget relates to a large payment for concessions, according to a spokesman. Of the overall 2009 capital program, 77% is for upstream activities, "reflecting the capital intensive phase of some of our long-term growth projects," he said.

And this week, BP
BP, -1.85%
said it expects to be able to grow production through 2013 from existing projects. It plans to keep this year's capital spend broadly in line with 2008 -- at between $20 billion and $21 billion, with lower spending in refining and marketing as it maintains investment in exploration and production.

"Companies like BP that have deep pockets will still plan for the long run as supply will be needed, but the small guys may not survive the next two years when demand looks like it will still be weak," said Mitsubishi Corp.'s Nunan.

Pieces intact

By November of last year, oil prices had dropped by about half from their record levels in the summer, and oil tankers were sitting idle in the ocean because of slack global demand brought on by struggling economies.

And by mid-December, oil had sunk to an intraday low of $32.40, its weakest level since April 2004.

"The prices had been driven so high that when they turned, the speculators quickly cashed in and left the market," said Perry, resulting in what he calls a "crash, or at least a precipitous drop" in the oil price.

But "oil is very much oversold now, just as it was overpriced last July," he said. He expects prices to "rise drastically in the next six weeks."

He doesn't expect prices to go above $100, but they'll more likely stop around $80 until the worldwide economy recovers.

Meanwhile, the factors that brought prices to almost $150 in the first place are still intact.

"All the same challenges the energy markets had before will crop up again in spades," said Kevin Kerr, editor of Global Commodities Alert. In a recent article, he said $300 oil could be one to three years away, but certainly not much more. See full story.

"We are certainly not seeing drilling increase or more refineries being built," Kerr said. "Demand will pick up and we will have wasted this precious time."

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